taxation 3

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School

Ryerson University

Department

Accounting

Course

ACC 333

Professor

Margaret Buckby

Semester

Fall

Description

Principles of Microeconomics: Market Equilibrium
MARKET EQUILIBRIUM
Linear Equations
We can analyze Demand and Supply and Market equilibrium with linear equations. These
are equations of the form Y = a + bX where a is the Y-intercept, i.e., the value of Y when X is
zero, and b is the slope (rise/run = ΔY/ΔX) of the function. We know that the function is linear,
i.e., a line, because the slope is constant. The slope is negative the Y falls with an increase in X
and is positive if Y increases with an increase in X.
Example: Suppose that the following equations describe the market Demand for and Supply of a
Economics book.
Demand: P =D120 – 0.2Q D Supply: PS= 30 + 0.1Q S (P is in $s and Q is in units)
We don’t need to label these equations Demand and Supply since the negative slope of the
first one and the positive slope of the second one tell us that they are Demand and Supply
respectively. Since equilibrium implies that PD= P Se simply equate the right-hand side of each
equation to find equilibrium.
Equilibrium => P =DP =>S120 – 0.2Q = 30 + 0.1Q
90 = 0.3Q => Q = 300
Q = 300 => P = 120 – 0.2*30 = $60 or P = 30 + 0.2*30 = $60
(P must be the same for Demand and Supply at equilibrium Q)
The following diagram depicts these equations and this equilibrium. Note that 120 is the
vertical (Y) intercept for Demand and that 30 is the vertical intercept for Supply. The horizontal
intercept for Demand is 120/0.2 = 600.
- 1 - Principles of Microeconomics: Market Equilibrium
Demand for and Supply of an Economics Book
Price ($s)
140
120
100
Supply
80
Po 60
40
20 Demand
0 Do
02 4 6 80 1 1 1 1 1 2 2 2 2 2 3 3 3 3 3 4 4 4 4 4 5 5 5 5 5 64 6 8 0
Qo
Quantity
GOVERNMENT IMPACT ON MARKETS
1. Fixed Prices
The government can fix prices to achieve policy objectives but there are economic
ramifications.
a) Price Floors (Minimum Prices)
A government may wish to protect producers against low prices by establishing a minimum
price (price floor) for a commodity. The classic commodities for price floors have been
agricultural products such as eggs, milk, or peanuts, but minimum wages and minimum
exchange rates are also common historically. A price floor is effective only if it is above the
equilibrium price since the market would move to the equilibrium price.
Governments assume or hope that the minimum price is a temporary measure to help
producers in a depressed market but the existence of a price floor above the equilibrium price at
that point results in surplus (unsold) commodities. It is difficult to simply decree minimum
prices since some producers will sell below minimum price on the black market thereby driving
- 2 - Principles of Microeconomics: Market Equilibrium
down the price. Governments usually have to establish the price floor, therefore, by purchasing
surplus commodities.
Example #1. Suppose that the government enacts a minimum price on textbooks by promising to
buy any surplus commodities at $70. The following diagram depicts this situation.
Goverment Price Floor
Price ($s)
140
120
100 Supply
80
PFloor
Po
60
40
Demand
20
Surplus
0
0 2 4 6 8 01 1 1 1 1 2 2 2 2 2 3 3 3 3 3 4 4 4 4 4 5 5 5 5 5 6 4 6 8 0
Qd Qs
We can find the specific amount of the surplus and the cost to the government of the price
floor by calculating the surplus as the difference between the quantity demanded and the quantity
supplied in the market at $70
$70 = 120 – 0.2Q D => Qd = (120 – 70)/0.2 = 250
$70 = 30 + 0.1Q S => Qs = (70 – 30)/0.1 = 400
=> Surplus = Qd – Qs = 400 – 250 = 150
Cost to the Government in buying this surplus = 150*70 = $10,500
Total Revenue of Firms = 400 * 70 = $28,000
Total Expenditure of Consumers = 250*70 = $17,500
NOTE: Price floors supported by government purchases have two problems:
- 3 - Principles of Microeconomics: Market Equilibrium
1. Governments must purchase the unsold surplus.
2. Consumers must pay a higher price.
Example #2. What is the effect of Minimum Wage Laws?
Economists use Demand/Supply analysis of price floors to criticize minimum wage laws
(but we will see later that this is a simplistic analysis). The diagram below depicts the Demand
for and Supply of unskilled labour in Ontario with the market at an initial equilibrium at Wo
(e.g., $8/hour), the price of labour and employment of Qo, the quantity of labour . Suppose that
the government imposes a minimum wage of W MIN (e.g., $9/hour) to increase incomes of
unskilled labour. What is the effect on unskilled workers of a minimum wage?
Wage ($s)
Supply
W MIN
Wo
Demand
Qd Qo Qs
Labour
Surplus
The diagram above depicts the initial equilibrium and the quantity demanded (Qd) and
quantity supplied (Qs) at the minimum wage. Notice that the increase in minimum wage
decreases the quantity demanded of labour by firms, resulting in a loss of unskilled jobs from Qo
to Qd. The loss of jobs for unskilled labour is even worse than this, however, since the minimum
wage attracts Qs – Qo workers into unskilled labour. Since these entrants probably have better
skills than the original workers, th